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IESE Research Papers,
IESE Business School

No D/292: Equivalence of the APV, WACC and flows to equity approaches to firm valuation

Pablo Fernández ()
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Pablo Fernández: IESE Business School, Postal: IESE Business School. Research Division, Av Pearson 21, 08034 Barcelona, SPAIN

Abstract: This paper shows that the three valuation methods (if used correctly) always yield the same result. The most striking result of this paper is that the Net Present Value of the tax shield due to interest payments (in the APV approach) should be calculated as follows in order to derive an accurate result: NPV OF INTEREST TAX SHIELDS = ƒ Dt-1 Kut T Â ------ t=1 t ' (1+Kut) t=1 T = Corporate tax rate / Kut = Cost of unlevered equity in period t / Dt­1 = Value of debt in period t­1 At first, it would appear that this formula implies that debt has a cost of Ku, and that the interest tax shields are discounted at Ku, but this is not the case. The Net Present Value of interest tax shields is not (and this is the main error in previous papers about this topic) the NPV of a single flow, but the difference of two NPVs of two flows with different risks: the NPV of the taxes paid in the unlevered firm and the NPV of taxes paid in the levered firm. Our formula is the difference of these two NPVs. Obviously, the flow of taxes paid in the levered firm is smaller but riskier than the flow of taxes paid in the unlevered firm. We show that, if used correctly, these three approaches to firm valuation will yield the same result. We apply these valuation procedures to perpetuities, to growing companies (at a constant rate g) and, finally, to any company. The main objective of this paper is to show that the three valuation methods always yield the same result. The paper also helps to think more about the meaning of the formulas and their relationships.

Keywords: Valuation methods; interest payments

JEL-codes: F10; F49

35 pages, April 12, 1995

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